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A trickle of defaults has begun in China. A deluge will soon follow.

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The debt disaster in China is not news; it has been building for years. China has relatively little debt at the national level but is buried under a mountain of debt incurred by provinces, corporations, banks and individuals.

If all of these debts are combined, China’s total debt-to-GDP ratio is over 250%, higher than the U.S. and about the same as profligate Italy. But the picture is worse than that ratio implies because much of China’s debt is owed in dollars, not local currency.

This means China is stuck on a treadmill of higher exports to earn hard currency to repay its dollar-denominated debt. If world growth slowed down or the U.S. went into a recession, China’s exports would fall precipitously and its ability to pay its debt would come under enormous stress. Still, China has been in this situation for years without undue consequences.

Analysts wonder if China can keep rolling over the debt and put off a day of reckoning until far in the future. This article suggests the answer to those questions is no.

Reuters reports that a local government in China has just defaulted on off-balance sheet loans of $629 million. The default is significant because a unit of government was the borrower as opposed to a corporation. Defaults by corporations have happened with some frequency, but government defaults are rare.

Beijing had ample funds to prop up this borrower if they wanted to. The default suggests that Beijing did not mind if this local government defaulted, perhaps as a signal to other towns and provinces to get their financial houses in order.

This default taken alone is not catastrophic. But it may be a sign of worse distress to come. If lenders pull back from rolling over government debt, that could cause a cascade of defaults that could spin out of control.

Even if the result is just to cause less borrowing and deleveraging by Chinese localities, that could slow economic growth because so much of China’s growth is driven by debt. Either way, it looks as if a debt debacle in China has now begun.

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